Tencent Music Entertainment Offers Margin Of Safety, But Not Good Enough

Summary

• Based on DCF valuation model, TME’s operating asset worth $11.3 per share, equity worth $12.2 per share, which is 26% higher than the current price.
• Revenue is growing at decelerate pace. It is driving by online music subscription, but the lucrative social entertainment services is facing severe competition from short videos.
• The new policy on exclusive content and advertisement will negatively impact on margins, operating margin is forecasted to decline to 7.7% in 2024, before climbing back to 10.7% in 2027.

TME’s share price hit all time high $32.25 in March, then fell 75% to it current price at $8.22. There are three phases in the decline: First is from mid-March to April, it was the victim of collapse in Archego Capital Management; Second is in early July after Didi‘s IPO and the government’s limiting on VIE structure; Third is after July 24^th, the government is specifically targeting TME’s exclusive content rights, alleging it’s monopoly in online music industry.

However, the massive decline makes me wonder whether TME is mispriced by the market. After all it is the dominate player in China’s online music industry, and it’s apps covers from music subscription, live streaming, social networking to long form audio. Back by China’s largest tech company Tencent, TME is strategically structured to monetize Tencent’s over 1 billion users on Wechat and QQ.

In the DCF model, I assume 6 years rapid growth period (2021-2027), the data come from 21Q2 quarter report and 2020 annual report, which are download from Capital IQ.

I. Revenue

TME’s revenues come from three areas: 1) Online music subscription, 2) Social Entertainment Service and 3) Ad & Sublicensing.

1) Online Music Subscription is the main revenue driver currently, and possible the only driver. The company has reported over 40% yoy increase in subscription revenue in the last four quarter, and the paying ratio went from 8.0% in Q2 2020 to 10.6% in 10.6% in Q2 2021.

I assume revenue from Online music services increases 30% in the next 12 month, 2022-2027 CAGR 18.1%. In short term, the policy on exclusive content rights will hurt paying user growth, however, China’s recent limit on underage children video game playing time and crackdown on after school education could help pushing children spend more time on music. Compare to Sportify’ s over 40% paying ratio, it is possible for TME to increase its paying ratio to 20% in 6 years.

2) Social entertainment services has been heavily impacted by short video apps, like Douyin (China’s Tik Tok) and Kuaishou. Revenue growth would come down to single digit next year. However, this part of business contributes the highest margin: ARPPU is RMB 153 compare to online music ‘s RMB9, while the cost of Karaoke licensing is lower than music streaming’s. In the last few quarters TME has heavily invested in Live Music streaming and multiple scenes of online Karaoke room. But we haven’t seen the decelerate trend reverse.

Revenue growth in the last two years were 18.6% and 11.5%. I assume this part of business grow at 3% next year, and CAGR 3.7% from 2021 to 2027. The pessimistic view reflects the management is lack of strategy to compete with Short video sharing apps. If ByteDance launch its online music app, TME’s social entertainment business could be impact further.

3) Advertisement had been the fastest growth business earlier this year. But new regulation on pop-up advertisement would affect growth, as the CFO confirmed in the latest analyst call. The MAUs on both online business mobile and social entertainment mobile has been declining, which make TME more difficult to increase Ad revenue.

II. Gross Margin

The gross margin of LTM Jun30-2021 is 31.7%, which is higher than Sportify’s 25.6%, as social entertainment service contributes higher margin. However, we saw gross margin has been declining in the last four quarters, and the CFO expected gross margin would keep going down in the next few quarters.

I assume gross margin fall to 30.0% in the next 12 months, further down to 29.0% in 2023. Then gradually stabilize at 30%. The falling gross margin reflects the company has to increase the revenue sharing ratio with content creator in order to keep them on its platform. Giving up exclusive content right could lower cost, but it takes years to see impact.

III. Other expenses

SG&A (include R&D) is accounted 20% of revenue in LTM Jun-30 2021, compare with Sportify’s 29.1%. I think the difference reflect two strategies: Sportify is a growth story, so it invested heavily to grow top line while sacrifices bottom line in near term. TME is positioned as Tencent’s monetization window of its over 1 billion users. Therefore TME become profitable in early stage.

However, as the competition become intense and MAU declining, TME would have to increase expense on R&D and marketing to grow. I expect R&D expense will climb from current 5.3% of revenue to 6.0% in the next 2 years. Overall expanses will increase to 21.3% of revenue in the next two years, then gradually narrow to 18.5% of revenue in 2027.

Thus operating margin will fall from current 11.7% to 7.7% in 2024, then climb back to 10.7% in 2027.

IV. Reinvestment

Assume 2021-2027 Capex is RMB 500 million per year, which is approximate to 1.2% of revenue. R&D expense is around 6% of revenue. Total reinvestment is around 5.2% of revenue.

FCFF increase at 12.5% CAGR in the next 6 years, which is quite healthy for a company. However, its RoIC averages at 6.8%, which is slightly higher than its WACC 5.28%. It means TME is creative value, but not very much. It also explains why TME’s valuation multiple is not as high as its peers.

V. Stock value

I use bottom up approach to calculate TME’s Beta. Its unlevel beta is 0.74, and levered beta is 0.78. The WACC is 5.28%.

Assume TME’s long term reinvestment rate is 25%, RoIC is 6.8%, so its long term stable growth rate is 1.7%. TME’s operating asset value is $11.3 per share. Add its investment holding in Universal Music Group, Sportify and Warner Music Group, it come out that TME’s share worth $12.2 per share, which is 27.0% higher than its Sept-13-2021 close price.

VI. Conclusion

From valuation prospect TME current undervalue, but it has bigger problems from both outside and inside. Exogenous risk come from rising competition and tightening regulation; endogenous risk come from slow revenue growth and higher expenses.

On September 13, China ordered its largest internet companies to stop blocking links from their rivals. This will only increase competition for TME, as people now can share music from multiple sources on Wechat and QQ.

I am hesitate to buy TME at current price, even though it’s undervalue, before seeing material improvement in its top line and margin.